Will Rising Rates Upend Your Bond Fund?

Should you be preparing now for the inevitable rise in interest rates?

A vintage financial bond.
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The risk with short maturities, though, is that interest rates don't rise and you get stuck with lower-yielding assets than you could have had otherwise.

There are other approaches, though. TIPs funds—for Treasury Inflation-Protected Securities—offer partial defense. They adjust for inflation, which tends to rise when interest rates do. The risk: In a period of deflation—like we had for a few months in 2009—the issuers suspend distributions. Also, rising inflation is not necessarily the same as rising interest rates, though one tends to accompany the other.

"We could be in an environment where rates are going up but there is no increase in inflation," notes Nathan Rowader, director of investments at Forward Management, which manages about $5.5 billion. "In that scenario, TIPS don't work as well."

You might also be tempted by floating-rate ETFs, like the PowerShares Senior Loan Portfolio (BKLN). It tracks a portfolio of senior bank loans—secured, variable-rate debt instruments issued by financial institutions that rate below investment grade. Bank loans are in favor when the market thinks rates will rise.

But, notes Rowader: "It's almost the exact opposite [of TIPS]. You get better protection from [rising] rates but if you have inflation, you might not get as much protection from those funds."

Should you consider junk bonds? They're less sensitive to rate changes, notes Rowader, because issuers have collateral that appreciates amid inflation, not incidentally reducing credit risk (the risk of default). Indeed, junk-bond ETFs like iShares iBoxx $ High Yield Corporate Bond (HYG) and JNK did rather well during a period of rising rates two years ago.

[See High-Yield Bonds Hit a Few Bumps, But Still Appeal to Risk-Takers.]

"I think a lot of individual investors—you can see it in fund flows—are moving toward passive high-yield options like junk or long-dated corporate bonds because they want the yield," says Rowader. "But I think they're ignoring the risk of the extra duration and the credit risk that comes with that."

If you're really feeling adventurous, you can buy funds that short bonds or try to double or triple their performance. "An investor could look at those, but we would by no means go anywhere near any sort of leveraged ETF," says Hickey. "Historically they've done a terrible job of tracking the indices they're supposed to track."

Or you could just bail on bonds altogether and dive into equities for the long term. "What we generally suggest is, given the low yields, you almost have a better risk/reward in high-quality equities or equity ETFs," says Hickey.

To be sure, most investors would be ill-advised to try any of these strategies on their own. There's a reason we hire fund managers, even if some of them seem overpaid at times.

"It's very hard to predict when interest rates are going to change," says Rowader. "If you have a good fund manager that has the flexibility to allocate across different asset classes to get income, you're going to be getting some extra teeth in determining when it's best to make those changes."